Saturday, January 21, 2006

How a tax credit can increase the cost of hybrid cars.

A new tax law this year provides a tax credit of up to $3,400 (varying by particular vehicle) to those who purchase cars with gasoline-saving "hybrid" gas-electric engines. But don't assume this credit will save you, the consumer, any money on the purchase of such a car. The fact is that it might cost you money.

Here are two steps to that unhappy result, through the Tax Code and supply-and-demand pricing.

First, the Tax Code. This going to be short: About 15 million taxpayers won't be eligible to take any "hybrid tax credit" at all in 2006 because they will be subject to the Alternative Minimum Tax (AMT). This is an alternative tax computation everyone must work through that generally imposes a lower rate than that under regular rules, but which also disallows many deductions and credits available under normal rules -- including that for purchases of hybrid cars. You must compare your AMT tax bill to the one computed under regular rules and pay the one that's highest. (The AMT story)

Who is subject to the AMT? People with higher incomes (over $75,000 or so) who have a lot of deductions, the prime one being for state and local income and property taxes.

That is, typically people who live in "blue state" cities and suburbs, where both incomes and local taxes are higher than the national average, and who have enough income themselves to spend a few extra thousand dollars to buy an environmentally friendly car for local driving.

In other words, the AMT targets exactly those people who are the most likely to buy a hybrid car, [update: incomes of hybrid owners, h/t The Chief] depriving them of the new credit for doing so. What Congress gives with one hand it takes away with the other (without exactly publicizing the fact).

That will be enough for many people -- before buying a hybrid while counting on this tax credit be sure you won't be subject to the AMT or the credit may be worth a big $0 to you.

But things can be even worse ... when you use a tax credit that turns out to be worth $0 to buy a car that has increased in price due to that very credit.

Second: supply-demand pricing. This is a longer story: Tax credits like this one are described by their proponents as reducing the out-of-pocket purchase cost paid by consumers, thus increasing demand, thus increasing the production of the favored product. But it doesn't have to work out that way.

By supply-and-demand we know that a car maker can sell a given number of vehicles at a given out-of-pocket price to purchasers -- say, 30,000 units at a price of $20,000. Adding a tax credit for purchasers to the situation doesn't change this at all. And this gives the producer the option of choosing to take 100% of the tax credit for itself as a gift from Congress, without increasing production at all.

Say the tax credit for purchasers is $3,000 per car. By still producing 30,000 units and raising the sales price to $23,000, the car maker closes the same number of sales at the same out-of-pocket price to purchasers, $20,000, as before. Purchasers net $0, production increases by 0, and the car maker collects a nifty $3,000 gift from taxpayers per car, $90 million total -- then sends a nice "thank you" note to its Congressman and extends the contract of its lobbying firm.

And, of course, any purchasers who have their credit disallowed by the AMT lose $3,000 in this scenario, compared to a situation where no credit existed and they paid the original market price.

Is such a thing likely in real life? Oh yes -- in the case of a product with inelastic supply that can't be readily increased, it is sure thing. Or if a producer chooses not to increase production for its own business reasons, the same will result. A tax subsidy purportedly for consumers will in fact be a disguised windfall bonus for producers.

(There's a moral here: Beware tax subsidies, they may not be what they seem. The fact that you take a tax break on your return does not mean that you are getting the benefit of it. But more on this another time.)

In the particular case of hybrid cars things won't happen to this extreme. Car makers are trying to build a market for this kind of car and increase production runs, so supply will be elastic, production will go up somewhat, this will mitigate the price increase to be less than the full credit, and the benefit of the credit will be shared with purchasers.

But we can be sure the car makes will be taking some of the credit. By supply-and-demand again we know that that for production to increase above the no-subsidy market level the car makers must receive a price above the original market price that purchasers would pay without the credit. And purchasers who were willing to pay $20,000 before, after being given a $3,000 subsidy, should be willing to pay somewhere up to $23,000 -- giving car makers that above-original-market price.

So we know that in reality this tax credit will increase the market price of hybrid cars, compared to what they would cost without it.

Let's look at some real numbers. Off-line data say Honda's suggested retail price for its 2006 Civic EX is $18,260, and for its Civic Hybrid, exactly the same car but for the engine, is $21,850, a difference of $3,590.

Is all of that $3,590 difference Honda upping its price to grab the tax credit? No -- but part of it is. (Note that none of the higher price results from any increased cost to Honda of the hybrid engine itself, compared to a conventional engine. Market price results solely from supply and demand -- cost of production plays no role but to remove from the market those producers who can't get a price that covers their production cost.)

So the bottom line is that the new tax credit for hybrid cars will increase the market price of such cars. That means the credit will be worth less than its dollar amount -- and if you are subject to the AMT it will cause you to take an outright loss on a hybrid purchase, compared to if there was no credit.

But look ... at this point you probably shouldn't be buying a hybrid for financial reasons, to save money, anyhow. For instance, to break even on gas savings after purchasing a Honda Civic Hybrid, gasoline would have to reach over $9 a gallon, according a recent report by Edmunds.com, with similar gas prices needed for other hybrids.

If you are going to buy a hybrid -- as opposed to the same car with a conventional engine -- the reason that makes sense is not money but the personal satisfaction obtained from knowing one is beneficially reducing the world's gasoline consumption.

Of course, the news about that isn't all good either.

research has been picking other holes in the hybrid story over the past two years. Consumer Reports, a product-rating publication, tested 303 vehicles in real-life town and highway driving, and found that nine out of ten of them failed to achieve the fuel-efficiency claimed for them in tests by America's Environmental Protection Agency (EPA). In some cases the shortfall was as high as 50% and the worst offenders were the hybrids...[Economist]

Data ... indicates that hybrid cars get less than 60 percent of EPA estimates while navigating city streets ... the Civic Hybrid averaged 26 mpg in the city, while the Toyota Prius averaged 35 mpg, much less than their respective EPA estimates of 47 and 60 mpg.[Wired]

Be an informed consumer. Buyer beware.

By the way, if you really want to improve the gas mileage a car model gets on a cost-efficient basis there's a proven, simple way to do it: get it with a manual transmission.

"The average stick-shift vehicle gets 17% to 18% better gas mileage than an automatic"[Smartmoney]

You'll get a lower purchase price for doing so too ... until Congress enacts another tax credit!